Douglas Goldstein, CFP®, is an investment advisor, president of Profile Investments (www.profile-financial.com) and host of the personal financial radio show, Goldstein on Gelt. Buy his new book on Kindle: Building Wealth: Investing in Stocks. Securities are offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, SIFMA. Accounts carried by Pershing LLC., Member NYSE/SIPC, a subsidiary of The Bank of New York Mellon Corporation. He can be reached at doug@profile-financial.com. Follow Doug on Twitter: @DougGoldstein.

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Will Using a DRIP Account Make You Rich? How to Improve Your Investment Return with Dividend Reinvestment and Compound Interest

If you like dividend paying stocks, consider adding DRIPs to your investment portfolio.

An Open End Fund lets you reinvest dividends. But an Equity Fund is not the only way to benefit from compound interest.

What are DRIPs? The term DRIPs comes from “Dividend Reinvestment Program.” Investors set up a DRIP account and then, instead of receiving the dividend income in cash, they get a DRIP dividend. That is, the dividends per share are used to buy more shares of the same common stocks rather than being paid out in cash. The same folks who might look to buy an equity fund or unit trust (we’ll define mutual funds in a minute) are often the same people who want to try to benefit from the compounded interest of a DRIP account. “Compounded interest” is actually the wrong term to use in this case because stocks pay dividends, not interest. However, having your dividends get reinvested feels a lot like getting compound interest.

DRIPs is a tool, not a strategy. As you read through this article, remember that you have many investment tools at your disposal. Reinvesting your dividend income is just one of many. Your ultimate investment strategy should be based on a careful financial review and diligent financial planning process.

Pros and Cons of DRIPs

Pros

Compound earnings. If you were to take all the dividend income that you received and spend it, you would miss out on the benefits of compounding interest. Instead, through a DRIP account, you can have each of the dividend payments buy you more shares of the same stock, thus increasing your ownership of that stock over time. Now, a DRIP account might take a while to grow, but slow-but-steady is a pretty good approach to investing. In fact, Albert Einstein is rumored to have said that “compound interest is the most powerful force in the universe.”

Make it easy to do regular, small investments. Let’s say that your common stocks pay you dividend income. It could take months or years for those dividends to accumulate. At that point, you would then have to go online or call your broker to buy you more shares. With a DRIP account, the shares get bought automatically. (By the way, if you’re a little unsure about what is dividend income, you can read a brief summary in the article called, “About Dividend Paying Stocks.”) Many investment systems work better when automated because they remove so much of the potential human error, and the DRIP dividend reinvestment system is no exception.

Dollar-cost averaging. Dollar-cost averaging is a system wherein you buy a certain dollar amount of an investment on a periodic basis regardless of the price of the investment. Using the dividend income from common stocks that you own works similarly. In dollar-cost averaging, let’s say you decided to invest $100 per month in a specific equity fund. If the price of the fund has gone up, you would buy fewer shares; if the price has decreased, you would buy more shares. In any case, you only spend the $100 that you have earmarked for the monthly purchase. This way, you end up buying more shares at a lower price and fewer shares at a higher price.

Dividend growth. When you own stocks that have a good dividend yield, you can always hope that you will see good dividend growth as well. You would hope that as a company’s profits improve, the board of directors would decide to increase the dividends per share. If you are regularly buying shares through a DRIP account, that dividend growth would mean that you would be putting more money into the stock. And if the stock does well, you’ll find that the annual percentage rate of return on your portfolio will look good. Obviously, though, this cuts both ways. If you let your dividend income regularly buy you more shares of the stock, and if the price per share decreases, you’ll be losing.

Cheaper fees. Using a DRIP account to buy more shares of a stock is not only easier than having to do it on your own, but in many cases it’s cheaper than going through a broker. Regardless of whether you trade with the help of a full-service broker or if you go online, there are always costs. Though reinvesting your dividend income through a DRIP account will entail some costs, they will probably be less than if you did the same trades through a broker.

Cons

Dividends are taxable regardless of whether you reinvest (though not in an IRA). Some people believe that if they reinvest the dividends that they receive, then they don’t have to pay tax on the dividends per share that they receive. Unless you own the stock in your IRA (Individual Retirement Account), the dividends per share are taxable. (This article is not meant to give tax advice, and you should check with your own CPA or tax advisor regarding your situation.) Uncle Sam views the receipt of dividends as a taxable event. If you choose to reinvest the dividends, it’s as if you had received the cash (on which you must pay tax) and then bought more shares. Though tax obligations should not discourage you from participating in a DRIP account, realize that the benefits of compounded interest that you are trying to achieve will be slowed down by the taxes you will pay.

Fees don’t really matter that much if you trade online. Though it’s nice to pay lower fees in a DRIP account, if you trade online with a low-cost online firm, and if you don’t trade too often, the savings on the DRIP account will be negligible. Though it’s true that if you want to increase your compound interest rate, it will help you to get as much of your money back into your investments as possible, but don’t drive yourself crazy over the fees.

Portfolios tend to not be diversified. As a financial planner, one of the most common mistakes I see with people who buy individual stocks is that they lack diversity. Rather than making a proper financial allocation, they tend to just own a few different stocks. If you look at the world of finance now compared to how it used to be, you will see that there are so many more tools that allow people to get a proper financial allocation so that they don’t put too much money in any one financial asset. In the world of finance now, for example, you can mitigate investment risk by buying stocks and bonds through an open end fund, a unit trust, or an Exchange Traded Fund (ETF). Diversification as a way to lower investment risk is so important in the world of finance now, that it’s surprising that people today still think they can pick they next winner. It’s shocking to find how many people think the way to wealth is to put most of their money in only one or two different stocks. Read “3 Reasons to Sell All Your Stocks Now“ if you want to find out about why you should not own individual stocks.

You can only buy stocks that offer DRIP programs. If you choose to buy stocks through a DRIP account, realize that not every company offers such a program. With so much opportunity in the marketplace today, why limit your choice? No one has ever completed the financial planning process and concluded that he should limit his investments to only those that offer dividend reinvestment.

Too much paperwork. If you don’t like record-keeping, DRIP accounts are not for you. Keeping track of all the investment income you receive and recording all of the purchase prices and fractional shares that you own in the DRIP account can make financial accounting a nightmare. And if you’re not going to do the financial accounting yourself, then mark down the cost of the CPA as another expense related to this investment.

Trade once a day. One key benefit of owning stocks is the liquidity that they have. Normal stocks and bonds investors appreciate that at any time during the trading day, they can call their broker and sell their position. With shares in a DRIP account, though, that’s not always the case. Frequently, these shares will only trade on a once-a-day basis, and you might even have to submit paperwork in order to do the trade. Who needs that extra hassle? Then you will not only have the business risk normally associated with stocks (that the underlying business of the stock will do poorly), but you now add liquidity risk into the equation. Low liquidity is not a good trait for any financial asset.

Alternatives to DRIPs

Mutual funds. What is a mutual fund? Simply put, a mutual fund is a basket into which investors put their money. The professional management team then makes all of the buy and sell decisions, leaving you free to live your life and pursue your own interests (presuming you’re not too interested in what is going on in the world of finance now.) Mutual funds normally give the option to reinvest dividends, so you benefit from the compound interest feeling of a DRIP account and yet own many, many stocks inside the fund instead of just a few individual DRIP stocks.

Money managers. Sometimes called “institutional money managers” or “separately managed accounts,” managed money accounts have professional management teams that not only do high level research on stocks and bonds, focusing closely on each financial asset, but they also design a financial allocation for the total portfolio to try to benefit from how they see the future of the market. On top of that, they can often manage the portfolio in a more tax advantageous way than mutual funds can. This can be critical for your overall financial planning process, since it’s not only important how much money you make, but how much money you keep after paying taxes.

Conclusion

To wrap it up, remember that there are pros and cons to every investment. If you want to go for a DRIP account, you’ll enjoy the benefits of compounded interest, ease of investment, dollar-cost averaging, the potential for dividend growth, and lower fees. On the other hand, you’ll still have the tax problem of having to pay tax on the dividend income even though you don’t actually get the money in hand, you may spend too much time focusing on fees when they don’t make much of a difference, your overall financial allocation may not be well diversified, you will have limited choices, poor liquidity, and you may be overwhelmed by the record-keeping.